Emotion vs. fundamentals?!

Most of us have little understanding of what makes equity markets move in one direction or another.

A long time ago, one of my professors explained to me: “It’s 5 percent fundamentals; the rest is determined by however big investors feel when they wake up in the morning.”

What about the experts? Well, according to Adena Friedman, president and chief operating officer of Nasdaq Inc.,

“Once emotion comes out of the market, fundamentals should prevail.”

Really, in markets that are by their very nature speculative, how can one distinguish between emotions and fundamentals?!

Unfortunately, the interviewer never followed up by asking Friedman to explain what the so-called fundamentals are and how she would know when those fundamentals, not emotions, are driving stock markets.

Addendum

Mainstream economists tend to be fervent believers in markets. They celebrate markets: they argue they should be free of intervention when they exist, and that they should be created when they don’t. Basically, they believe, markets are efficient institutions, populated by rational actors, which maximize individual and social welfare

But something different happens when it comes to equity markets, especially when they are declining, such as the past few weeks. Markets are no longer efficient, reflecting the “fundamentals,” and actors are no longer rational, but are instead guided by something else, “emotion.”

In sum, the traders who make stock market prices seem to have a few things wrong: China is not as big a deal to us as they think; and falling oil prices should help, not hurt, U.S. growth. Don’t misinterpret any of this as investment advice, however. The market can stay irrational longer than you can stay solvent.

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The market cap of a stock today, excluding the effects of mergers on valuation, should be the NPV of all future dividends. That’s the estimated sum of all future dividends from now until the company winds down, discounted by a formula to account for uncertainty, and further discounted by another formula that expresses a preference for income now rather than years or decades later.

And there’s the problem. How can these two discount factors be anything but emotional wild guesses? Traditionally we think a price/earnings ratio in the range 5x to 20x is reasonable, but why is that? Why not 30x or 100x? Well, if investors feel the future is uncertain they’ll tend towards the low P/E multiple. If they’re optimistic they’ll accept P/E ratios over 20 as we’ve had recently. This is not a swing in the estimate of total future profits, but rather an emotional swing in the discounts applied to calculate NPV.

Just about the only time fundamentals impinge on a stock valuation is when the company is about to be sold or wind down, or when both are likely as in the case of an ailing company. In that rare case we have a concrete estimate of total future dividends plus disposal price and the disposal event is close enough, within a year or so, that the NPV discounts are small.

That’s the only time stocks are really driven by fundamentals. Any other time, it’s emotional risk and NPV preferences.

Pavlos, well said. Historically, over the very long term and across secular bull and bear markets, the average real, currency-adjusted total return was the average dividend (all inflation- and currency-adjusted price appreciation of a secular bull market is wiped out by the end of a subsequent secular bear market).

Additionally, the stock market is not a wealth-creating vehicle but a wealth-transfer mechanism, distributing overwhelmingly disproportionately financial wealth to those who already possess most of the wealth: the top 0.001-1%.

I’ve testified in dozens of dockets where discount rates and stock valuations were issues. What Pavlos says is precisely what I have experienced. Long ago I began including disclaimers in my testimony that the discount rates and stock vales chosen for testimony reflected policy preferences as to the goals of the actions under review in the docket. And that it is impossible for anyone to make any other validly supportable claim.

As to markets (equity markets in particular) and economists I say this. What economists believe about markets is this: 1) they and their friends (the rich and powerful) can more easily control markets and thus get their way than they can control government regulations and regulators; 2) they and their friends are quite often smarter (or at better educated) than all the other people and companies involved in the market – whereas regulators are as smart as or smarter than economists and their friends; 3) finally, and of most convenience economists (and their friends) control how markets look and operate, and the theories that supposedly explain them – thus economists and their friends can always change any inconvenient or non-favorable aspects of markets anytime and in any fashion they choose. I give you the continued use of CAPM in evaluating public utility future stock values and returns. A procedure any half-wit knows doesn’t work and quite frequently is so far in error as to lead to disastrous policy decisions by regulators (disastrous for customers anyway).

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